Time to question assumptions about ‘natural offsets’

The correlation between shifts in the Aussie dollar and commodity prices is not as predictable as it was three years ago, meaning finance teams may need to re-examine their assumptions about natural offsets.
AFR

by
Sally Rose

Many commodity producers and companies with a high exposure to commodities prices have historically chosen not to hedge against any currency risks on future transactions, citing a “natural offset" between Australia’s currency and commodity prices.

“Recently that risk management strategy has been challenged," says Oakvale Capital executive director Paul Travers. “The assumptions the natural offset approach to risk management is based on may be breaking down."

"The problem is not so much the volatility in commodity prices, but that the dollar is remaining consistently high" says Travers. “The metals market, including base and precious metals, has been the most impacted . . . as well as iron ore and coal."

"It’s not just the recent change in the correlation between commodity prices and the Aussie dollar that matters, but also the increase in the volatility between the two," says Mark Woodruff, head of foreign exchange sales for Citi in Australia and New Zealand.

“What’s happening at the moment is commodity prices appear to be a lot more volatile than the currency," says Woodruff.

While the finance chiefs in affected companies are all aware of the problem and many are worried about it, they are at different stages of figuring out what to do about it," says Travers, although he is already seeing a little more hedging activity, particularly from the resource companies he works with.

“A number of companies that have never hedged before are starting to at least think seriously about it," says Travers. “And many of those which did hedge already changing the way they do it," says Woodruff.

This issue is particularly notable for the many Australian companies which over the past decade have moved away from having the Australian dollar as their functional currency to operating with the US dollar as their functional currency says Woodruff.

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Company Profile

The changing relationship between the Aussie dollar and commodity prices was a hot topic of conversation among the 17 treasurers and CFOs – collectively responsible for more than $150 billion in market capitalisation across a range of sectors – in attendance at a recent annual roundtable held in Australia by Citi’s corporate solutions group and derivatives structuring team out of London and Singapore.

Citi is “not recommending vanilla hedging programs that are set in stone", says Woodruff, “but there are a number of types of policy frameworks can put in place to manage this risk and stabilise returns". Such as, “dynamic hedging programs that take in to consideration both underlying corporate exposures and the valuation of the currency".

“The second thing companies are doing is transferring some of their correlation risk on their balance sheet to banks," says Woodruff.

Travers’s team at Oakvale recently reviewed the changing correlation between the Australian dollar and the price of gold, copper and coal since the 2008 global financial crisis when commodity prices dropped sharply as did the Australian dollar.

While the correlations over the three-year period from July 2009 to June 2012 are close, the relationship has been diminishing. “Looking at just the most recent one year period the correlation is very low," he said. The correlation between the dollar and copper prices has dropped from above 0.9 over the past three years to 0.6 over the past year. Gold prices followed a similar trend.

It is uncertain whether the breakdown of the natural offset between currency and commodity prices will be a permanent change or even long term. “It may be that when the correlations are measured again three years from now that it will be very high. Perhaps what we are seeing now is an aberration? Or we may find the low correlation holds," says Travers. However, he thinks the divergence is going to be here for at least a couple of years.

In August, OceanaGold announced a new corporate refinancing facility. There were four key terms in this agreement, two of which related to hedging practices.
OceanaGold
is an ASX-listed gold producer with mines and assets in New Zealand and the Phillippines. It invoices in New Zealand dollars and about 70 per cent of its cost base is also in New Zealand dollars.

The company’s only exposure to the Australian dollar is from its head office expenses. However, it has “seen some favourable correlation between the New Zealand dollar and the gold price which has provided the company some natural hedging," says finance chief Mark Chamberlain.

But its New Zealand dollar-denominated cost base will soon be diluted with the commissioning of the company’s Didipio Gold-Copper Project in the Philippines in the last quarter of 2012. “The cost base will change and be less weighted in New Zealand dollars and more weighted in US dollars," says Chamberlain.

Silver Lake Resources
is an ASX 200 listed gold producer and explorer with projects in Western Australia. All of the company’s sales are processed in Australian dollars. It does not hedge its US dollar or gold price exposures, but is closely monitoring the potential need to do so in the future.

“At this stage [Silver Lake Resources] don’t hedge gold or the US dollar," says chief financial officer, Peter Armstrong. The company has “never hedged the US dollar, but has on occasion done some forward sales on gold, just to fix the margin."

Every month, Armstrong gathers information on what prices are available on forward sales and then compares them to where he thinks gold prices are going to go. The board sits monthly and reviews the decision not to hedge.

There is no particular trigger in the risk management policy that would prescribe the company change its hedging practices. For now, the volatility remains something the company believes is in its shareholders’ best interest to remain exposed to.

“The gold price still has somewhere to go." As long as that’s the case, Armstrong says he is “quite comfortable sitting and watching."

Similarly, the company does not hedge any of its costs, although this was reassessed about 12 months ago. “Following a review of diesel prices it was decided there wasn’t any real benefit in hedging that cost," says Armstrong.